TAX FREE

LIFE INSURANCE
An Untapped Investment
for the Affluent

LYNNLEY BROWNING

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But private placement life insurance, as it is

known, is still unfamiliar to many wealthy people
and trickier to design properly than even some savvy
investors realize, tax lawyers and financial advisers
say.
It sounds so good I can invest tax-free and get
the money but its actually very complex, said
Jonathan Blattmachr, a retired estates and trusts
partner from the Milbank Tweed law firm in New
York.
Private placement life insurance is an investment
wrapped inside an insurance policy. The Internal
Revenue Code treats the taxation of insurance
differently from that of investments, like stocks or
hedge funds, and does not levy federal income tax or
the 15 percent capital gains on a life insurance policy
when it pays out upon the death of the holder. So by
stuffing an otherwise taxable investment inside a taxfree life insurance policy, investors can reap the
compounded gains of that investment and the death
benefit, all tax-free.
The insurance is a form of variable life insurance
whose cash value depends upon the performance of
investments held in the policy. It is particularly
lucrative because hedge funds,
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which trade frequently, otherwise often carry the 35

percent short-term capital gains tax.
William Waxman, a principal at Waxman Cavner
Lawson, an insurance broker for the wealthy and a
financial adviser in Austin, Tex., said that demand
for hedge funds, even in a down market, is driving a
lot of the private placement insurance market. Still,
he said, the private placement life insurance industry
was relatively small; the cash value of all policies
outstanding amounts to perhaps $4 billion to $5
billion. While brokers pitched the policies to many
family offices on the East Coast, he said, West Coast
offices appeared less tapped.
There are other lucrative benefits besides the
absence of income taxes. When structured properly,
the gains and the death benefit can escape estate
taxes and go to your heirs tax-free when you die. If
structured through an offshore entity, like a foreign
trust, the gains can remain out of reach of creditors
or those who might sue you.
But investors appeared to be shying away from the
foreign variant, Mr. Waxman said, in part because
you have very sophisticated estate planning lawyers
in the United States,
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but they dont necessarily have offshore practices.

Investors may also be able to borrow up to 90
percent of the gains from the policy without paying
taxes on the loan. One exception is when the policy is
structured as a modified endowment contract, or
M.E.C.; then, the amount borrowed is taxed at
ordinary rates, typically 35 percent, and may carry a
10 percent penalty tax.
Investors who buy an M.E.C. version do so solely
to pass on the death benefit free of income and estate
taxes to their heirs, not to access gains tax-free before
then. The Internal Revenue Service considers the
policy an M.E.C. if the investor has paid in all the
premiums due over the first seven years a
limitation intended to prevent the rapid financing of
tax-free benefits.
Investors must also meet several hurdles. They
must be an accredited investor and qualified
purchaser as defined by the Securities and Exchange
Commission, which means they must earn at least
$200,000 a year and have investable assets of at least
$5 million. The insured must qualify medically for an
insurance policy in other words, not hooked up to
life support in intensive care.
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But tax lawyers say the most difficult hurdle

concerns restrictions around the choice of the
investments. The private placement part means
that the investor must be willing to choose, from a
list preselected by the insurer, the bonds, stocks,
hedge funds or other investments in which
premiums will be invested. In other words, you cant
try to stuff in your separate hedge fund investment, a
move that can run you afoul of the Internal Revenue
Service.
And you cant stuff in paintings or other
valuables, Mr. Waxman added. He said the policies
were not good for those wanting to invest in private
equity, because the latter can be difficult to convert
to cash.
Gideon Rothschild, an estates and tax lawyer in
New York who specializes in offshore versions of the
policies, said the people who can buy them are
control freaks and tend to think they can invest
better than anybody, including the hedge fund
manager, and thus often shy away from them.

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Though the policies require only a couple of

premium payments, they are hefty. Insurers that sell
them typically require at least a $1 million prepaid
premium for a $10 million policy, and others require
$5 million. Some policies have a value as high as

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$100 million or more, with the total premiums due

ranging from $10 million or more each. Big sellers
include MassMutual, the American International
Group, New York Life, the Phoenix Companies in
Hartford and Boston, Prudential, John Hancock and
Crown Global Insurance.
But the various fees that can be owed in addition
to the premiums are typically well below fees for
other forms of investable insurance.
They can include a one-time sales load charge, a
required annual mortality expense, the monthly cost
of insurance, a state premium tax and a deferred
acquisition cost. If a trust or foreign corporation is
set up offshore to house the policy, there are other
fees, including one paid to the trustee of the entity
that owns the policy.
If the policy owns hedge funds, investors may also
be required to pay the typical 20 percent cut of
profits and a 2 percent management fee to the fund.
The total fees associated with an onshore policy
vary, but Mr. Waxman said that, as a guideline, we
try to make the total cost of the whole thing 100 basis
points or less of the cash value of the policy. (One
basis point is one one-hundredth of a percent, so 100
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basis points would be 1 percent, or $50,000 on a $5

million policy.)
Lawrence Brody, an estate planning partner at the
Bryan Cave law firm in St. Louis, said that you have
to have the financial capacity to buy one of these, so
that its not too tempting to have a $100 million
policy on your life and somebody whos a beneficiary
who might want to kill you to collect the death
benefit. You will want a billion or so in net worth,
and the insurer will probably even require it.

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Fidelity Financial Co., LLC

215 S. 88th Street
Omaha, NE 68114
Mark T. Houston
(402) 880-7008
mark@fidfin.co

WWW.FIDFIN.CO

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